Description

The SAFM and PPC write-ups in the past by Siren81 and fiverocks19 are required reading. These are excellent primers on the industry and a give great insight into the history of the chicken cycle.

Thesis Summary: PPC is currently experiencing above-average earnings, largely due to an unusual chicken cycle resulting from changes in genetic breeds. However, it's important to remember that the chicken industry is still fundamentally a commodity market. We expect market conditions to normalize within the next 12 months as supply adjusts to the current high-margin environment. Early indicators of this shift are already visible. While we recognize we may be early, it's worth noting that changes in this industry can occur rapidly. Our analysis suggests that when the cycle does turn, PPC could face a potential downside of 37%.

Business Description: Pilgrim's Pride, a publicly traded subsidiary of JBSS3 (Brazil), is the second-largest chicken processor in the US at 17% market share. it also maintains leading chicken positions in Mexico and the UK. The company follows the industry standard of vertical integration, overseeing most aspects of production from breeding to distribution, while partnering with farmers for grow operations.

PPC's US chicken portfolio is diversified across four main segments:

1. Big bird (30%)
2. Small bird (30%)
3. Tray/retail (30%)
4. Prepared products (10%)

These segments represent a spectrum of commodity exposure, with big bird being the most susceptible to market fluctuations. Small bird and tray/retail segments benefiting from contractual agreements and cost pass-through arrangements, which help to moderate cyclical effects. The prepared products segment focuses on value-added and branded items, typically yielding higher margins and providing the most insulation from commodity price swings.

COVID & Current Cycle Set Up

As 2020 approached, the chicken industry was emerging from a multi-year upcycle, with expectations of an extended downturn. However, the COVID-19 pandemic dramatically altered this trajectory. Initially, supply disruptions and inflationary pressures benefited processors as chicken prices nearly doubled, more than offsetting increased grain costs. This led to a surge in chicken processor margins.

The landscape shifted again during the economic reopening. Consumers pivoted away from chicken and grocery foods, favoring restaurant-centric proteins like beef. This change coincided with producers' ongoing expansion of production capacity. Consequently, chicken prices plummeted by 50%, while grain prices remained elevated at 70% above pre-COVID levels. The result was a sharp contraction in chicken processor margins, reversing the earlier gains.

This background sets the stage for the current cycle, which, like previous upcycles, is driven by a genetic issue. Over the past decade, the US chicken flock has seen an increasing prevalence of 'Woody Breast', a condition where chicken breasts become overly muscular, tough, and undesirable for human consumption. This was an unintended consequence of breeding chickens for increased muscle mass. To address this issue, the two dominant genetic suppliers, Aviagen (privately owned, European) and Cobb-Vantress (owned by Tyson Foods), introduced new bird varieties. These new breeds were designed to be less muscular while maintaining high yields and feed conversion rates. The new birds largely achieve these goals, with reduced 'Woody Breast' incidence, improved feed conversion, and increased breast yield. However, this genetic shift has led to some unexpected outcomes. The new birds are eating too well, resulting in overweight chickens. This excessive weight gain is problematic, as heavier birds tend to be less active, reproduce less effectively, and produce offspring more susceptible to disease.

The overweight birds resulting from the new genetic breeds are experiencing reduced hatchability and increased mortality rates. These factors are constraining the supply of chickens, keeping prices elevated. Simultaneously, grain prices are returning to pre-COVID lows. This combination of restricted supply and lower input costs has driven chicken margins to record levels.

Unit Economics

The core unit economics of chicken production revolve around two primary factors: sale price and feed cost. A typical big bird requires 8 weeks to reach market weight, consuming approximately 12 pounds of feed during this period. The feed composition is roughly 80% corn and 20% soy by volume. 

To gauge the industry's profitability trends, we can plot high-level big bird margins over time. While this approach has limitations—it excludes certain costs, doesn't account for contract pricing, and doesn't fully capture the lag effect due to the chicken's lifecycle—it provides an indicator of the business's margin dynamics.

Late Cycle Timing Becoming Favorable

Tyson Foods (TSN), owning its breeder Cobb-Vantress, led the shift to new bird genetics. This early adoption exposed them to hatchability and mortality issues as early as 2021. However, their first-mover status also positioned them to be the first to address these challenges. TSN's improvements stem primarily from iterative genetic refinements, selectively breeding to mitigate problematic traits. Additionally, TSN has implemented the use of low-level antibiotics in chicks to enhance disease resistance, a strategy other processors may need to consider. As a result of these changes, TSN recently reported their hatch rates are approaching 83%, ~500 basis points above industry averages.

The rest of the industry, primarily supplied by Aviagen, is expected to close the gap with TSN over time via breeding improvements, increased labor utilization, and expanded antibiotic use. These efforts are already underway to resolve the current challenges.

Recent data indicates that the chicken industry is beginning to respond to price and margin incentives by increasing supply. Both chicken eggs set into incubators and chickens hatched are showing +MSD% year-over-year growth. Additionally, the average weight of birds is trending towards big bird categories, primarily commodity birds, as processors are maximinzing margin per pound. This supply response suggests we should anticipate increases in total slaughter and production volumes in the coming months. If breeding issues are resolved concurrently with this supply expansion, it could potentially lead to oversupply in the latter part of the cycle.

Valuation

PPC likely does >$5.00 per share this year, reflecting peak earnings. The stock currently trades at ~9x this level. During prior peaks, PPC has rerated down to 7x trough multiple on peak earnings, suggesting peak target price of $35, or 20% downside. PPC's recent performance appears driven by speculation of an extended cycle.

However, we estimate normalized EPS is closer to $2.70. This projection assumes a 10% decline in US chicken pricing and US margins reverting to normalized 6-8% range, while maintaining sell side proejctions for UK and Mexican operations. PPC's normal multiple is 10x, implying a $27 price target or 37% downside.

It's worth noting that when the cycle eventually reverts, it often overcorrects to the downside. While we won't speculate on precise trough EPS or valuation, it's important to recognize the potential for significantly greater downside if an extended oversupply condition develops following this upcycle.

Risks

• As long as the industry struggles with hatchability and mortality issues (and grain prices remain low), PPC is likely to continue generating significant profits and potentially increase dividends. This could lead to a special dividend payout.
• JBS could acquire the remaining 20% of shares. While this has been discussed previously, the risk appears low due to JBS's cost-conscious approach. For instance, JBS has refrained from using PPC subsidiary funds for substantial share repurchases at current prices, citing the favorable deals they secured in previous buybacks at lower price points. JBS will likely prefer allocating capital to cyclically depressed sectors (such as North American Beef) or businesses that would further diversify their portfolio.

Catalyst

- Processors ramp chicken supply

- Genetic breeding issues are fixed over the next 6-18 months